You can get retirement income from many sources. These include your employer’s plan for 401(k), an individual retirement account, and taxable brokerage accounts. Bonds or annuities are also options to generate regular income. However, they work in different ways. One is a debt instrument, the other an insurance policy. The strengths and weaknesses of each will be highlighted by understanding the differences.
Bonds vs. Annuities: The Basics
Understanding the basics of annuities and bonds as investment tools is key.
A bond is an IOU or debt. You are basically lending your investment dollars to another entity when you purchase bonds. To fund public works projects, municipal bonds can be issued by cities and towns. The bonds are purchased by investors and then the money is used by the municipality or town to fund road construction, or improvements to the public water system. Other entities can also issue bonds, including the federal government and some of its agencies. Bonds can also be issued by corporations.
Each bond specifies the term of the bond. It also specifies the interest rate that will be paid to investors on certain dates. The bond’s face value is repaid if the investor holds it until maturity.
Bonds can be held in either a fund or directly. The interest income is typically a fixed amount, and payments are made on a predetermined schedule.
An annuity is an insurance contract. Annuities are available from financial advisors, insurance companies and individuals. An annuity can be structured in many different ways, but they are generally designed to provide an income stream.
You may, for example, purchase a deferred and annuity when you are 50. The annuity will pay out at 65. You make regular premium payments towards the annuity from age 50 through 65. This is known as the accumulation phase. At 65 years old, you start receiving monthly payments from your annuity. This is known as the distribution phase.
These income payments can be for a fixed period or for the remainder of your natural life, depending on how your annuity was set up. Annuity payments can also be passed to your spouse or other beneficiaries upon your death. An annuity that is immediate can be purchased. This means that payments start within one year.
Annuities, like bonds, can earn interest. You can choose from:
- Fixed annuities are guaranteed to earn a fixed rate of interest.
- Variable annuities are an investment-based variable that earn a variable rate.
- Indexed annuities are an option that aims to replicate the performance of benchmarks or stock market indexes.
Fixed annuities are the most risky, while variable annuities can be more risky.
The pros and cons of bonds for retirement income
Bonds can be used to generate income in later years, but there are pros and cons.
These are the advantages
- You can plan your retirement budget easier because returns are predictable.
- Bonds may offer higher rates of return than an annuity.
- Diversification is possible across different types of bonds . Corporate bonds, Municipal bonds, Government Bonds, and Agency Bonds.
- It is relatively simple to buy bonds.
- Municipal bonds do not attract tax
There are disadvantages
- Income payments are only for a fixed period, and then the bond matures.
- Bonds can be risky; if the entity issuing them defaults, you may lose your initial investment and interest payments.
- As interest rates change, bond prices and yields can fluctuate.
Interest rates and bond prices move in opposite directions. Therefore, if interest rate rises, then bond prices will fall and vice versa. These movements can have a direct impact on the performance of your bonds, as well as rising or falling inflation.
The pros and cons of annuities for retirement income
Annuities have the same advantages and disadvantages as bonds. Here are their strengths and weaknesses.
These are the advantages
- Annuities can provide a guaranteed lifetime income for you and your spouse.
- Fixed annuities offer predictable rates of return while indexed and variable annuities provide higher returns for investors willing to take on more risk.
- Annuities are tax-deferred. This means that you won’t have to pay taxes until you start receiving distributions.
There are disadvantages
- Annuities may have higher fees than bonds, but they can also be more expensive.
- If you withdraw money from an annuity prior to the distribution phase starts, you may be subject to a surrender fee or early withdrawal tax penalty.
- It can be confusing to understand annuities because there are so many.
Annuities can provide income for your entire life. This can be reassuring if there are concerns about whether you have enough saved in an employer’s plan, IRA or other savings plans.
The bottom line
Annuities and bonds provide income in different ways. Your income goals, risk tolerance, and other sources of income will all play a major role in deciding whether to include either one or the other in your retirement plan. While you might be inclined to one or the other, it is possible to include both in your investing and retirement planning.
- Talk to a financial adviser about the pros and cons of annuities vs. bonds for your retirement income. It doesn’t take long to find the right financial advisor for you. SmartAsset’s free tool matches your needs with local financial advisors within five minutes. Get started if you are ready to match with local advisors that will help you reach your financial goals.
- Learn about the performance characteristics of different bonds. There are many types of annuities so it is important to know what they look like. You can compare the costs and potential returns by looking at the fees that you may pay for annuity.